GAO report should trigger rethink of accountability in higher education

To borrow $43 million and pay it back almost immediately may appear a rather pointless exercise. But for Corinthian Colleges, a now-defunct chain of for-profit colleges, it was a clever way to bamboozle regulators and keep federal subsidies flowing with no strings attached.

For all private colleges that receive student aid funds from the federal government, the Department of Education calculates a measure of “financial responsibility,” intended to identify which schools might be in choppy financial waters and thus at risk of closure. But the financial responsibility score formula rewards rather than penalizes colleges for borrowing, so long as the debt they take on is long-term. That creates strange incentives for a college with a middling score.

According to an Education Department Inspector General report released earlier this year, Corinthian manipulated its financial score by borrowing $43 million in long-term debt on the final day of fiscal year 2011. It recorded the debt as long-term, boosting its score to a level that would not trigger additional federal oversight. Then, fiscal year 2012 rolled around and Corinthian immediately repaid the loan. The exercise worked so well that Corinthian repeated it in 2012 and 2013 with larger loan amounts, while the Education Department remained three steps behind.

In 2014, the Education Department subjected Corinthian to increased financial oversight, but never secured any collateral from the school for the risk it placed on taxpayers. Less than a year later, Corinthian shut down for good. Thousands of its students had their student loans canceled under a rule that grants loan forgiveness to the students of closed schools. Even more students had their loans canceled after Department officials determined that Corinthian had defrauded many of them.

At last count, Corinthian’s failure has cost taxpayers $550 million in student loan discharges, a number expected to rise. The pace of college closures, both for-profit and nonprofit, has accelerated in recent years, putting students and taxpayers at risk. And if Obama-era regulations to expand loan cancellations (currently delayed and under revision by Education Secretary Betsy DeVos) go into effect, the cost of school closures will only go up.

All this heralds a boondoggle that would put Solyndra to shame. Yet according to a scathing Government Accountability Office (GAO) report released on Wednesday, the Department of Education’s established method of predicting which schools are likely to close is out of date at best and completely useless at worst.

The “financial responsibility composite score,” ostensibly a gauge of each college’s financial health, has a poor track record of predicting school closures. Schools which receive a failing score must undergo additional federal oversight and post collateral to protect taxpayers from losses in the event of closure. But according to GAO, half of schools that closed in the past six years (including Corinthian) received a passing score from the Department, meaning they were not required to post any collateral. And 80% of schools that received a failing score in 2011 were still open as of 2016.

The Department’s formula for calculating financial responsibility scores was last updated in 1997. In the intervening years, accounting boards have updated financial reporting standards and a global economic crisis has upended what we know about the determinants of financial health. Schools such as Corinthian have figured out ways to manipulate their scores. Among the problems GAO identified with the Department’s scoring:

Changes to accounting practices have affected how institutions report financial metrics. But the financial responsibility formula is tailored to old reporting practices, meaning audited financial statements do not contain all the information necessary to calculate a score. The Department must therefore solicit some unaudited information from schools to calculate scores.

Financial responsibility scores do not emphasize liquidity. Even wealthy institutions may face financial troubles if they do not have easily spendable assets, a danger now better appreciated following the global financial crisis. Failure to understand the importance of liquidity contributed to the collapse of Lehman Brothers, among other things.

The scores focus on a single fiscal year, rather than looking at each college’s finances over time. Studying past and anticipated performance is standard practice in the private sector, since analyzing trends makes it easier to pick up on early signs of trouble. GAO notes that private credit rating agencies gave “junk bond” ratings to 30 colleges with passing financial scores from the government.

Scores do not consider nonfinancial factors, such as accreditation and legal problems, which nonetheless have an effect on a school’s chances of closure.

Colleges can manipulate their scores, as Corinthian did for years. A disproportionate number of schools have scores just above the passing threshold, which is consistent with some score manipulation.

Despite these problems, the Education Department sees little need to update the financial responsibility score formula. The Department argues in its response to GAO that “any financial measure that the Department would use for evaluating financial health could be manipulated.” While the Department should not dismiss its ability to improve the formula, it does underscore a larger point: the government does a poor job of identifying and protecting itself from risk.

Bureaucracies move slowly by nature. Even if the government had updated its financial responsibility formula after the invention of the iMac, it would still face a fundamental incentives problem. The Education Department does not go out of business if it loses money on a fiasco like Corinthian Colleges; taxpayers take the hit instead. The Department thus has no financial incentive to make sure its tools for predicting school closures, and the massive taxpayer costs that come with them, are up to snuff.

Private companies, on the other hand, do go out of business if they cannot make ends meet. Usually, this is a force for good, since it compels companies to innovate and stay ahead of the competition. But in higher education, federal involvement has turned this feature into a bug. Consider Corinthian: the for-profit chain had a strong incentive to stay several steps ahead of the Department’s accountability regime, since Corinthian’s continued existence relied on access to federal money. It therefore figured out ways to manipulate its financial responsibility score in ways the government could not anticipate.

Rather than attempting to outfox the private sector at its own game, regulators should recognize their own limitations and instead use market forces to hold colleges accountable. Here’s how this could work: for each institution that receives federal aid, the Education Department calculates its potential losses (due to student loan cancellations and other costs) in the event of a school closure. It would then require colleges to purchase insurance on the private market for that amount. If a school closes, the insurance company would cover the Department’s losses and thus hold taxpayers harmless.

As profit-seekers themselves, private insurance companies have an incentive to limit payouts. Schools at a high risk of closure would need to pay higher premiums, nudging those institutions to keep their financial houses in order. Those at low risk of closure would pay lower premiums. Colleges which reduce their dependence on federal subsidies would consequently reduce their required amount of insurance coverage, thus rewarding independence from government funds.

The Education Department would no longer need to rely on its flawed and outdated financial responsibility scores to gauge colleges’ risk to the taxpayer. While no method of predicting closure is perfect, private insurance companies would have an incentive for continuous improvement. Competing insurance companies would put armies of analysts to work identifying new risk predictors and discarding obsolete ones. Under such a system, debt-manipulation shenanigans would not mask Corinthian Colleges’ precarious financial condition for long.

The GAO report provides the perfect opportunity to rethink how the federal government approaches accountability in higher education. That process must start with recognition of the government’s limitations and failures, which put millions of students and billions of taxpayer dollars at risk. On financial responsibility in higher education, regulation is too important to be left to the regulators.